CFDs are relatively new financial derivatives that have become increasingly appreciated among investors, especially in the Forex market. But as with any other activity, to be successful while trading CFDs, you need to have the right set of tools – the most important one being your broker.
Of all the different CFD brokers available, almost all fall within 2 overall categories – ECNs and Market-Makers. While a novice user may not notice much of a difference between them, the behind-the-scenes mechanics are substantially different. These differences have a significant impact on you, the trader, whether you realize it or not.
What are the differences between an ECN broker and a Market Maker, and which one is best for your trading style? Let’s jump right in.
What is a CFD and how does it work?
CFDs, which stands for Contract For Difference, are financial contracts you have with your broker to exchange the difference between the opening and the closing price of a trading position.
When you trade CFDs, you do not own the underlying asset you’re investing in, as you are only getting (or paying) the difference in price between the value of your contract when you opened it and when you closed it.
CFDs are leveraged financial products, allowing you to use margin trading to profit from increased market exposure. Every time you want to open a trading position, you have to put aside a fraction of the total value of this position as collateral – this is the margin.
As a result, you are able to invest more money than what you possess in your trading account. Consequently, as leverage amplifies price movements in all directions, they can be risky – you might make larger profits, but you could also lose just as much.
In addition to leverage, one of the biggest advantages you have, when you trade CFDs, is that you can benefit from rising as well as falling markets, which means that you can earn money regardless of the market direction.
Why are CFDs popular in the Forex market?
The Forex market is the market dedicated to currencies. It is one of the most liquid and active financial markets in the world, and it is open 24-hours a day, 5 days a week. It is also the largest financial market, with US$ 5.1 trillion exchanged every day.
If you decide to trade the Forex market with CFDs, you can do so by borrowing capital from your broker to place a trade. This is called margin trading.
Trading CFDs on Forex currency pairs is very popular, as it is an ideal market for leverage and margin trading due to its high liquidity, as you can enter and exit the market quite easily with small slippage. Of course, leverage can be offered on many different markets, but leverage, as applied to the Forex market, is generally much higher than any other trading instrument.
Because CFDs are very risky leveraged products that are linked to speculation, they are not allowed everywhere. For instance, there are forbidden for US residents, but they generally are permitted in many other countries.
In Europe, the European Securities and Markets Authority is the deciding authority on the rules brokers need to follow when it comes to trading CFDs. Recently, the organization decided “to strengthen restrictions on the marketing, distribution or sale of contracts for differences to retail clients”.
Forex Brokers Regulations also varies in different parts around the world, as it is a fast-growing OTC market.
What are the different types of CFD brokers?
A “No Dealing Desk” Forex broker usually provides direct access to the interbank market and can either be an STP or an ECN broker (or a mix of both).
This type of broker only sends trading orders directly to liquidity providers, which means that it doesn’t bear the risks of its clients internally. They only act as an intermediary between trader orders and the liquidity providers available.
ECN, which stands for “Electronic Communication Network”, describes the broker type that is connected to an electronic trading system in which many buying and selling orders from different large liquidity providers compete. Therefore, an ECN broker only connects different market participants together, so then they can trade with each other.
STP stands for “Straight-Through-Processing” and describes a broker that does not execute trader orders. They only carry out trading operations, without human intervention (No Dealing Desk – NDD) to external liquidity providers connected to the interbank market.
Dealing Desk (DD) – Market Maker
A Dealing Desk Forex broker is a Market Maker, which means that they don’t offer liquidity provider prices, as they are the ones providing liquidity for its traders by offering their own prices. It is for this reason that they are called market makers, as they “create” the market for their clients. This means that they are the ones setting the bid and ask prices of any financial instruments offered.
A Dealing Desk broker is very often the counterparty of their traders’ positions, as they do not directly trade, or hedge their clients’ position, with their liquidity providers. Therefore, a Dealing Desk broker has to pay for profitable client trades with their own money. If a client makes a winning trade, the broker loses money – and vice-versa.
How do CFD brokers make money?
A No Dealing Desk CFD broker earns money on the trading volume of their clients, as it receives a commission on all trades, and/or a markup on the spread (the difference between the buying and the selling price). Most of the time, these spreads are variable spreads, which fluctuate depending on the market conditions.
A Dealing Desk CFD broker usually gets money from spreads, as well as client losses. Spreads offered by market makers are usually fixed spreads.
The most important thing for a No Dealing Desk broker to provide is the best trading conditions for their clients – that way, their clients are more successful, they trade more, and everybody earns more money. It is for this reason that most traders prefer to use an ECN or STP broker, as they find them more reliable and profitable.
As a market maker broker earns money from their traders losing money, it is often seen as less transparent, as they have the ability (and motivation) to manipulate prices. Revenue is usually higher for a Market Maker than for an ECN/STP broker, given the same trading volumes.
CFDs are complex financial products that are not suitable for everyone, as leverage can trigger big losses. But, leverage also means that you can make huge gains on the financial markets by using volatility to your advantage.
CFDs are generally a good fit if you’re a short-term trader (like a scalper or a day trader), and if you have time to spend in front of the markets. Most importantly, to trade CFDs you need to have a high tolerance for risk – especially if you’re trading the Forex market, as it’s a very volatile market.
To better protect your trading capital, always use tight money and risk management rules when trading CFDs on the FX market. Equip yourself with the right suite of trading tools by selecting the right broker for your trading needs.
Regardless of whether you choose a dealing or a non-dealing desk broker, both can be perfectly reliable. Trading with No Dealing Desk broker, like SimpleFX, is likely to be a better choice, both for avoiding the conflict of interest inherent in the Market Maker model, and for partnering with a broker whose interests are aligned with yours.
To find the best broker for your trading needs, be sure to:
- Establish your preferred trading style and your requirements first
- Make sure your broker is regulated and licensed (in the more regional markets the better)
- Be sure that the broker’s client support is knowledgeable and easy to access
- Open a demo account first to know if the trading platform is going to be a good fit for your trading strategy
- Check out trading conditions:
- Minimum/maximum deposit
- Margin requirements
- Financial assets
- Trading platforms
- Type of trading accounts offered